Solution for The New Global Financial Architecture

The 2008/09 economic and financial crisis taught the world an important lesson: while the nature of the financial industry has become truly global, with an increasing number of actors and institutions ...

The 2008/09 economic and financial crisis taught the world an important lesson: while the nature of the financial industry has become truly global, with an increasing number of actors and institutions on the credit market, regulation is still highly fragmented among different national supervisory authorities. To maintain systemic stability and prevent contagion, more is required than merely ensuring the orderly operation of individual financial institutions. Different regulators—including monetary authorities—must cooperate in order to achieve better, but not necessarily more, regulation. Better regulation should aim at identifying overleveraging and emerging vulnerabilities, ensuring the adequate pricing of risk, and promoting better incentives for prudent behavior. In pursuing these targets, regulation will require changes to institutional structures, the content of rules, and especially the structures of supervisory agencies.

Until recently, economic orthodoxy considered the question of imposing capital controls invalid. Financial liberalization was lauded because it enabled capital to flow to where it would be used most productively, increasing national and global output. However, the International Monetary Fund now agrees that constraints on capital outflows might be useful in specific circumstances.

Overall empirical support for the benefits of capital-account liberalization is weak. The case for liberalising trade in goods and services is strong, but the case for complete capital-account liberalization is not. One reason is that many modern financial flows do not play the useful role in capital allocation that economic theory assumes. Net capital flows are often from relatively poor countries to rich countries. Large two-way gross capital flows are driven by transient changes in perception, with carry-trade opportunities (borrowing in low-yielding currencies to finance lending in high-yielding ones) replacing long-term capital investment. Moreover, capital inflows frequently finance consumption or unsustainable real-estate booms. It is therefore important to distinguish among different categories of capital flows. Some are valuable, but some are potentially harmful.

Foreign direct investment (FDI), for example, can aid growth, because it is long term, involves investment in the real economy, and is often accompanied by technology or skill transfers. Equity portfolio investment may involve price volatility as ownership positions change, but at least it implies a permanent commitment of capital to a business enterprise. Long-term debt financing of real capital investment can play a useful role as well.

By contrast, short-term capital flows, particularly if provided by banks that are themselves relying on short-term funding, can create the risk of instability, while bringing few benefits.

The required policy response should integrate domestic financial regulation with capital-account management. Tax instruments and reserve requirements that put sand in the wheels of short-term capital inflows should be combined with strong countercyclical measures, such as additional capital requirements, to slow domestic credit creation.

However, the effectiveness of such measures is undermined if global banks are allowed to operate in foreign countries in branch form, providing domestic credit financed by global funding pools. Therefore, it is crucial that banks have to operate as legally incorporated subsidiaries, with locally regulated capital and liquidity reserves, and strong regulatory limits on the maturity of their funding.

Such requirements would not prevent useful capital flows: global banking groups could invest equity in emerging markets and fund their subsidiaries’ balance sheets with long-term debt. In banking, as in other sectors, investment that combines long-term commitment with skill transfer can be highly beneficial, which implies that foreign banks should be free to compete on the same basis as domestic banks.

Neither this reform nor any other can magically make the instability of global credit flows go away. But this measure, along with others, would help reduce the danger that domestic credit and asset price cycles, of the sort which wreaked havoc in the financial crises of both 1997 and 2007/08, can be magnified by volatile capital flows.